Most people like to be helpful when they can. As a result, when a close friend or family member is in a bind and asks for your help, your first question is likely to be, "What can I do?" Even when money's tight, you'll probably be willing to give someone in need a little cash to tide them over.
But there are some forms of help you should consider carefully before offering, even when a close friend or family member makes a request. One of these things is providing a guarantee on a loan. Agreeing to guarantee someone else's loan, also known as co-signing, isn't something you should take lightly. Whether the loan is from a big bank like US Bank, a sub-prime lender like Dollar Financial, or a pawn shop like EZCORP, co-signing involves obligations that go far beyond what most people think about when they agree to help someone out.
Loan guarantees and you
The idea behind requiring a co-signer on a loan is pretty simple. When a bank or other lending institution considers whether or not to give someone a loan, the lender is sometimes unwilling to make a loan based solely on that person's income, assets, and credit history. In some cases, especially in dealing with students in high school or college, the loan applicant may not have any resources upon which the lender can rely in deciding whether or not the loan is likely to be repaid in a timely manner. In other cases, bad credit history or insufficient earnings may not meet the lender's standards for certain types of loans. However, if the applicant can find someone else with a better credit history or a stronger ability to repay the loan who will agree to guarantee the loan if the applicant fails to pay, then the lender will be willing to grant the loan.
Guaranteeing a loan can be deceptively simple. In many cases, all a lender will do is run a credit check to determine if your credit history is good enough to give the lender assurance of your ability to pay. However, loan guarantees are serious business and can get you in trouble quickly.
When things go wrong
Most people understand that when they agree to be a co-signer on a loan, they're agreeing to repay the loan if the original borrower doesn't pay. But when you inquire further about the exact details of how the guarantee process actually works, most people have only a vague idea of the particulars.
Lenders are extremely careful to give themselves as much flexibility in collecting on delinquent loans as they possibly can. In many cases, if a borrower misses a single payment on a loan, the lender can immediately demand full repayment of the entire outstanding balance on the loan. The default can also trigger additional penalties, including late fees, higher interest rates, and other charges.
When a co-signer is involved, the lender generally has considerable leeway in deciding how to collect the loan. As a co-signer, you can't assume that you'll be able simply to step into the shoes of the original borrower and assume the same payment schedule that the borrower had. Furthermore, contrary to popular belief, lenders often don't have to go after the original borrower before trying to collect from the co-signer. Indeed, if the original borrower had a bad credit history and the lender relied on your good credit in granting the loan, then the lender won't waste time trying to obtain repayment from the borrower directly. But when you look closely at the terms of your loan guarantee, you may see that the lender reserves the right to take action against you regardless of whether or not it also tries to convince the original borrower to repay the loan. While the lender can't be repaid twice, it can try to collect from everyone in an effort to take payment in full.
Ruining your credit
In addition to leaving you exposed to a big loss, guaranteeing someone else's loan can be detrimental to your own credit health. A loan guarantee is a use of your credit, so if you try to take out a loan for your own personal needs, the fact that you co-signed on someone else's loan may make your lender nervous about extending additional credit to you.
Moreover, co-signing for someone else can result in linking your credit history to the original borrower's actions. For instance, if the person whose loan you're guaranteeing regularly makes late payments, then you may find that the negative impact of the borrower's actions will hurt your own credit as well.
More than friendly help
Given the potential adverse consequences, you should be absolutely sure you're comfortable co-signing on a loan for a friend or family member. Conversely, if you're in a position in which you need to ask someone to co-sign a loan for you, you should treat that loan as the most important obligation you have. Situations like this one can stretch a relationship to the breaking point if not handled with the utmost care. Also, make sure you understand the exact terms of your loan guarantee before you sign anything. Lenders will do everything they can to protect themselves, so you have to do the same to protect yourself.
Helping others is a good thing to do when you can, but you still have to take care of yourself. Co-signing on another person's loan is beyond the regular call of duty, and you shouldn't feel bad if you decide it's not worth risking your own financial stability to do it.
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Fool contributor Dan Caplinger never asked his parents to co-sign any of his loans. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't abandon you in your time of need.